While the terminology or label might make you feel special, and some of these investments do perform as may be anticipated, what does it really mean to you?
Regardless of the label or the sales pitch, do you really know what you bought?
Be Careful! You will likely be asked to provide financial data in order to qualify, and you may be asked to sign additional paperwork – consider the following as you are listening to the sales pitch, as these investments typically have one or more of the following characteristics:
- Risk. Private equity documents generally state that an investment in a private equity fund is speculative, involves a high degree of risk, and is suitable only for persons who are willing and able to assume the risk of losing their entire investment. Do not listen to the glowing sales pitch and ignore these warnings, or allow a financial advisor to in any way downplay the risks.
— Are you really asking for recommendations that could risk gambling your retirement savings or nest egg, can you really afford to lose it all?
- High-costs. Private equity investments charge a number of different fees and expenses and they are not always clear to the uninitiated. To say these fees and costs are opaque would be an understatement, as it is not only difficult to determine and calculate the fees and costs, but the names and labels for these fees and costs can vary widely. These are not traditional stock and bond investment funds and the expenses and fees that are being generated are rarely fully understood and rarely easy to calculate.
– Are you willing to guess at the amount of higher fees and costs for an investment product you do not fully understand?
- Illiquidity. Private equity investments do not typically trade on a recognized exchange. With no available liquid market, most do not permit sales or redemptions during the life (generally 10-13 years, but may be as long as 50 years) of the investments. The investments are long-term in general. You generally will not be able to redeem or sell.
– For most investors, the prospect of a long-term, illiquid, expensive investment product does not make much sense.
- Lack of transparency. These investment products lack transparency. There is no updated accurate pricing available, no accessible market. Details or information is not easy to come by or easily understood by most retail investors.
– Are you willing to invest your hard-earned dollars in a “black box” investment strategy?
- Unknown or Unpredictable Strategy. The fancy term for this is “unconstrained” and whatever strategy you think you may be buying into, is not guaranteed, and can likely change at any time. If the strategy changes, so do the risks, and that is unfortunately after you have committed your funds.
– Are you comfortable investing in a strategy that can change materially and involve unknown or unanticipated risks?
- Leverage. Private equity funds generally reserve the right to use a leveraged strategy. This is a fancy way of saying debt or borrowed funds might be used, and the risks can be increased dramatically, and can change over time. You may never know or appreciate the level of debt or leverage at any given time, and you may not know or appreciate the level of risk.
– Are you comfortable adding leverage risk to your investment strategy, and not knowing the extent of the increased risk exposure?
- No assurance of diversification. One of the fundamental hallmarks of sound investment management is having a well-allocated and well-diversified investment portfolio. The old adage is not to put too many eggs in any one basket. These investment products often reserve the right to invest 100 percent of their assets in a given sector or a particular investment, with no requirements for asset allocation, or diversification. That lack of diversification can greatly increase risk.
– Are you comfortable with your eggs in one basket, and not knowing which basket it might be?
- Lack of Regulation. These investment products are not regulated in the same manner as traditional stocks, bonds, mutual funds and they are not subject to the same degree of regulation.
– Are you comfortable knowing that you may be jumping without a net?
- Offshore Risks. Most of these investment products are part of a web of related entities some or all of which might be domiciled outside of the United States for various reasons. The legal, regulatory, operational and custody risks related to offshore as opposed to U.S.-based entities involved in the sale or issuance of investment products can differ greatly. The use of offshore tax havens, such as Cayman Islands, may be used to obtain certain benefits, but also involves additional risks for investors as those jurisdictions often lack the legal, regulatory and operational safeguards offered in the U.S. In addition, having funds custodied by entities incorporated and regulated under the laws of foreign countries present unique risks.
– Are you comfortable with your knowledge of the laws, rules, regulations and lack of regulatory safeguards in a foreign country?
- Conflicts of Interest. These investment products are subject a number of conflicts of interest. These conflicts of interest can occur at various layers involving the investment managers, issuers, and others. Everything from the valuations to the calculation of fees can involve one or more interested parties with their thumb on the scale. The performance fee structure often creates incentives to the investment manager to take risks or calculate valuations of opaque investment holdings in a manner that is in potential conflict with the interests of the investors.
– Are you comfortable with illusory valuations driving inflated fees from you to the investment manager?
- ERISA Issues. These investment products often allow investment managers to withhold complete and timely disclosure of material information regarding assets in their funds. They will argue that this is their proprietary strategy, and disclosing it will put them at a competitive disadvantage. The offering documents may note the nondisclosure policy may violate applicable laws. That is a very broad sweeping reference to the fact that the investment manager may violate U.S. laws such as ERISA regulations.
– Are you truly comfortable knowing that you are agreeing that your investment manager may not have to follow laws, rules and regulations that were created to protect investors?
- History of Bogus Fees and Improprieties. According to a 2014 internal review by the SEC, more than half of about 400 private-equity firms at that time that SEC staff had examined charged unjustified fees and expenses without notifying investors.
– Are you comfortable knowing that this is was the case just a few years ago?
- Transaction Fees. These investment products often charge transaction fees that may be in violation of securities laws, as the transaction fees are charged without first registering as broker-dealers with the SEC.
– Are you comfortable investing in products where additional transaction fees may be charged in violation of state and federal laws, rules, and regulation?
- Under-Reporting of Fees. According to a New York Times article, the rates of return and hidden costs related to private equity investments are difficult for investors to identify. Certain fees are fairly standard, some are tied to performance, and then there are a host of potential under-reported fees and charges, including transaction fees, legal costs, taxes, monitoring or oversight fees, and other administrative or other expenses charged.
– Are you comfortable knowing that there could be additional fees and costs for illiquid, non-transparent investments that may be little more than an investment manager gamling at your potential expense?
